Thursday, June 21, 2012

Externalities, asymmetrical information, and other collective action problems are even more pervasive in economic life. Countless ways of conducting business reap gains for some while imposing unjust costs on others. Create a cartel. Stuff rat feces in sausages. Engage in insider trading. Dump toxic waste in rivers. Market useless medicines. Withdraw renewable resources at unsustainable rates. Stuff insurance contracts with obscure loopholes, collect premiums from customers, and then deny their claims. Fill corporate boards with cronies who reward top managers with huge bonuses even when they fail to meet contracted performance requirements. Rig the terms of a complex loan to trap financially unsophisticated borrowers into spiraling debt and fees. Get rating agencies to certify worthless assets as AAA. Use leverage to reap profits from self-generated asset bubbles, sending the global economy into financial collapse when they burst. Without extensive regulation, markets happily accommodate such negative-value-added business plans. Tomasi sometimes acknowledges this fact. But he puts a heavy thumb on the scales against regulation by describing economic activity in general in terms of “self-authorship” and “economic liberty.” Such descriptions cut no normative ice with respect to destructive or predatory business plans. Nor should judges, who lack the expertise to assess economic regulations designed to stop such abuses, use such exalted abstractions to strike them down."

The point of the essay is to offer a critical review of Tomasi's Free Market Fairness. I've not read Tomasi's book yet, so my comment here is about the conceptual view in this quotation.

It seems to me the first two sentences in the quoted paragraph are making use of the normative framework of economic efficiency. Specifically, reference is made to what sounds like a negative externality because it is asserted that there are ways of conducting business that are thought to impose unjust costs on others. While this sounds like a negative externality, and thus a market failure, it seems well off the efficiency mark to me.

I will admit that many economists have used the phrase "imposed costs" when discussing negative externalities, and this has been done for quite a long time now. I think there have also been not just a few economists who have told negative externality stories by talking about "the victims" of imposed external costs. However, such ideas are not really expressing the conceptual conclusions that fall out of negative externality models.

The problem of negative externality market failure is not that businesses, or consumers, "impose" costs on others. The efficiency problem is not that there are victims of the actions of businesses, or the actions of consumers. The problem, pure and simple, is that the allocation of resources that characterizes the market equilibrium (for a perfectly competitive market) is inefficient when a negative externality is associated with the market.

From the normative point of view of efficiency there are no victims and no one is at fault. When there is a negative externality the market simply fails to achieve an efficient allocation of resources when a market equilibrium is reached. If this doesn't seem to be correct to you, then consider the way in which the negative externality market failure can be corrected. The correction is of course a Pigovian tax, or an excise tax, which is equal to the marginal external cost at the efficient quantity of output. The idea is quite simply that a market fails to allocate resources efficiently when there is a cost which is "externalized," or that is to say, a cost which is not internalized in the choices taken by buyers and sellers. To fix the efficiency problem the troublesome costs have to be internalized through the use of a Pigovian tax. No one needs to be punished, no personal fault needs to be assessed, and no one needs to be compensated on efficiency grounds. The correction involves a bit of "tweaking" to "fix" the market by internalizing the marginal external costs.

Note also that since on efficiency grounds there are no victims and there are no persons to fault for efficiency transgressions, there seems to me no meaningful concept of "unjust" external costs. There may well be "unjust" costs associated with the economic activities of people that lead to air pollution, but such costs have to be called "unjust" on normative grounds other than economic efficiency.

Moving on the what comes next in the quoted paragraph, consider whether any of the actions in the list of suspect business practices and plans are associated with negative externalities.

The creation of a cartel is not a negative externality. It would result in a monopoly market failure. Efforts to create a cartel are associated with "collective action problems," but not from the social point of view, only from the point of view of the "collective" which in this case is the cartel. As Mancur Olson explained in The Logic of Collective Action we should expect very few cartels to exist without the force of government helping to hold the cartel together. Of course this also means that if we think we see a cartel within the United States it is probably the result of government policy.

Stuffing rat feces in sausages is not a negative externality because there is no third party, only a buyer and a seller. It is certainly a bad business practice, but it does not result in an inefficient allocation of resources. I can suggest at this point a pretty handy way to decide if there is a negative externality involved. Assume there is a negative externality and consider the Pigovian tax that would be needed to correct the inefficiency. In the case of rat feces stuffed in sausages, we would ask government to impose a Pigovian tax so we achieved the efficient amount of rat feces in sausages (don't forget now that the efficient quantity of rat feces is zero only in very special cases). If the policy response seems silly, like it does in this case, then there probably is no negative externality!

Dumping either toxic or nontoxic waste in a river is probably the classic illustration of a negative externality. So, here is the case that perfectly fits my explanation above that the efficiency problem is not associated with victims or with the unjust imposition of costs. The problem here is that without a means of internalizing the marginal external cost the equilibrium allocation will have an inefficiently large amount of toxic or nontoxic waste in the river. Perhaps government compulsion can get the efficient amount of waste in this case, perhaps not.

I shouldn't think that insider trading was a negative externality efficiency problem. Just that word "insider" suggests otherwise, don't you think? Don't misunderstand, I can be convinced that insider trading is something of a policy concern, but not on the grounds of negative externality, or even on the grounds of efficiency concerns associated with asymmetric information. Insider trading seems to me to be associated with the specific rules and regulations governments have created over many years because of the earlier government action to allow the formation of corporations with limited liability. And, the policy concerns may well be efficiency concerns, but I'm inclined to say these efficiency concerns are a classic illustration of government (efficiency) failure.

Well, I could go on with the rest of the list, but I'm getting a bit tired of this exercise, and I suspect you are as well. I just thought I could write a few things down that would help my future students understand what the concepts of efficiency, market failure, and negative externalities really mean. Plus, if former students take the time to read this, I'm hoping they will be reminded of why I've urged them to: JUST SAY NO TO EXTERNALITY ABUSE!